Pricing in Inflation: Where is core CPI inflation headed?

The unrelenting increase in producer prices, represented by the wholesale price index (WPI), and the widening gap against its retail complement—a quarterly 6, 7 and 9 percentage points to December 2021 respectively—raises the question about eventual pass-on of increased costs to the consumers. At headline level, CPI inflation’s decline from May reversed last September; core retail prices increased nearly14 basis points in the last quarter while the gap against its producer equivalent peaked at -7 percentage points in October. Nonetheless, the gap in two core inflation rates is way above historical trend (Chart). In this instance, even with core retail price growth picking pace, the distance from producer price increases is persistent and large for almost one year. With improving economic activity, the question is about the pace and extent of catch-up in core CPI-inflation. Where is it headed in forthcoming months?

A difficult question that eludes a straightforward answer. For example, there’s a clear reversal in the tendency of core retail inflation to be higher than the producer counterpart—about 1.5-2 percentage points on average. Past responses of core-CPI inflation have also been rapid, e.g., the mid-2017 resurgence in commodities’ inflation saw core retail price growth quickly cross 5%, its long-term average value and above the usual 4-5% range, and reach 6% and more. In the current instance too, core-CPI inflation accelerated similarly above 5% last year (August 2020) in response to core-producer price increases, breaching 6% last May with the pace maintained on average to December 2021.

The question is if core-CPI inflation will go beyond 6%?

On one hand, the visible pipeline pressures from elevated producer prices and the fact that these have never sustained for so long in the past suggest the rate of core retail inflation may well be poised to cross 6% soon. Especially so if economic improvement is as strong as generally claimed to be.

However, the small-sized response of core-CPI inflation—about one-tenth of the trough-to-peak price change at producer level in past one and half years to December 2021—is telling. Covid may potentially have overturned the predictiveness of historical trends perhaps. It provokes interest about aggregate demand strength, i.e., the output gap or the distance between actual GDP from potential growth, which is material to future adjustments in or the path of core retail inflation.

Two scenarios can be visualised in this context, depending upon the size of the output gap or what its perceived to be. If actual GDP growth is significantly below potential growth, i.e., large, and negative output gap, as is commonly believed, then the lack of pricing power will continue to limit selling price revisions or pass-through. Core-CPI inflation could then soon moderate, possibly after price increases announced for this quarter have played out. Alternately, if potential growth has lowered—e.g., shrunk due to Covid-caused damages to output, and/or the preceding slowdown that ended in growth collapsing to 4% in 2019-20—then further increases in core-CPI inflation with elevated persistence cannot be ruled out.

Yet another outcome, viz., rising core-CPI inflation coincident with enlarged spare capacities, cannot be dismissed altogether. This could be due to oligopolistic market structures, increased concentration, and/or protection; or an increased gulf in purchasing power from enrichment, losses, and unequal distribution of incomes. Such features enable firms to pass on costs to affordable consumer segments despite pressures of demand contraction. Notable elements of recent pricing behaviour indicate that in the September 2021 quarter, the strong corporate profit growth was pricing driven while volume growth contributed just 10%, according to Nielsen. Last quarter’s early results suggest profits of fast-moving consumer goods’ firms (FMCG), e.g., the bellwether, HUL, were wounded by inflation while volumes grew only 2%. In the same quarter, core retail inflation paced faster (see graphic). In 2021, large firms hiked prices at least 2-3 times; in the first quarter of 2022, reports say consumer goods’ firms contemplate price increases in the 4-10% region, the white electronic goods’ companies are set for another round (6-10%) and so are auto manufacturers who raised prices several times last year.

Still, the pass-through to consumer prices has been visibly limited. This could indicate an overestimation of the output gap perhaps. Or market imperfections, concentration, fragmented consumer segments, or other distortions. 

Which of the above scenarios materializes is a matter of immense interest. Not in the least because the impetus from ultra-low interest rates has now waned, increasing pricing pressures. This is the opposite situation to that in the post-2014 period – then, real interest rates remained high, but the sharp collapse in oil-commodities’ prices widened the divergence in producer and consumer prices to an average -8.3 points monthly at headline level and -5.73 points in core-inflation rates between Jan 2015-May 2016.

Policymakers are evidently apprehensive. Following November’s fuel levy reduction, the government has since banned futures trading in seven commodities, extended import tenure of pulses, reduced import duty on refined palm oil, and imposed stockholding limits on soymeal. The last monetary policy committee (MPC) meeting minutes also reflect concern over pipeline pressures: Mridul Saggar cautioned WPI inflation warranted close watch given record-high momentum in October, matching diffusion, and elevated, sticky core inflation. RBI Deputy Governor Michael Patra expected elevated inflation to persist, including from selling price revisions, until the second half of 2022, after which the demand-supply mismatches are expected to improve.

If past asymmetric behaviour is a guide, the catch-up in core-CPI inflation could be faster and quicker, given these remain largely unchanged when WPI inflation is negative, but adjust upwards with alacrity. In other words, retailers do not tolerate cost pressures for long. Or maybe the sizable economic slack may overturn this trend. We should know this soon. 

The author is a New Delhi-based macroeconomist.